Most investors are mystified how top hedge funds can consistently beat the market year after year. Granted, hedge funds have access to some of the greatest minds in the world, the most advanced equipment money can buy, and greatly reduced transaction costs. Regardless of these advantages they do in fact employ genuine alpha creating strategies many individual investors can also follow.
One of these strategies is the analysis of catalysts when purchasing a stock. When a retail investor purchases a stock many times they will buy it because they feel it is a good value which is not indicated by its price, in other words it is trading below its intrinsic value. The fact much of the information available about the stock has been priced into the stock. For example, I can create a portfolio stocks with P/E ratios less than 7 that I feel are trading below their intrinsic valuation, but that does not mean in any way that this portfolio will beat the market. Regardless of the fact that the stocks in the low P/E multiple portfolio trade at roughly half the earnings multiple of the market. Although low multiple stocks may seem like a good value, without a catalyst it is likely the market will not discover their true intrinsic value and they will stay mispriced. All of a sudden the market is not going to realize a stocks true intrinsic value, it will take either a fundamentally game changing piece of news (catalyst) or an acquisition. A good hedge fund is able to find mispriced stocks with a catalyst in their near future which will lead the market to bid up the stock to its true intrinsic value. Essentially they are attempting to find stocks that currently trade at a P/E of 7, but they feel the stock will trade at a P/E of 14 in the near future due to a catalyst.
What is a catalyst? A catalyst can be a variety of things but for this article let's assume definition is news or an event changes the future earnings prospects of a company.
Example 1: Apple (AAPL)
For Apple a Catalyst could be the successful launch of its speculated new Apple TV. A launch of a new product category that will likely be very profitable for Apple will improve the earnings outlook for Apple therefore commanding a higher P/E on increased earnings multiple meaning a substantial increase in stock price.
Example 2: Ford (F)
An example catalyst for Ford would be a raising of the company's debt to investment grade by ratings agencies. Since Ford has debt of over 90 Billion dollars a lower cost of capital could dramatically benefit their bottom line. Additionally a rating of investment grade for the company's debt would also inspire confidence among investors, commanding a higher P/E multiple. So if Ford's debt is rated investment grade its stock price will rise to accommodate higher earnings at a higher P/E multiple
As you can identifying catalysts is not difficult and allows a value investor to experience gains from realization of true intrinsic value. An ideal trading strategy for trading a company with a catalyst in its near future would be to accumulate the stock during dips to average down your cost. After the catalyst has been realized you can either sell out right or sell call options against the stocks and get called away while collecting premium from selling options.
Disclosure: I am long F.
